The US government continues its enforcement focus on crypto assets

Two recent developments demonstrate the government's continued focus on cryptocurrency enforcement.

First, on February 17, 2022, the US Department of Justice (DOJ) announced that it was appointing its first director of the National Cryptocurrency Enforcement Team (NCET). The creation of NCET, which was formed on October 6, 2021, brings together a dedicated team focused on cryptocurrency prosecutions. As we previously discussed in this New York Law Journal article, its creation was likely prompted by the increasingly frequent ransomware attacks on American companies. The DOJ's recent announcement explained that "NCET will identify, investigate, support and pursue the department's cases involving the criminal use of digital assets, with a particular focus on virtual currency exchanges, mixing and tumbling services, infrastructure providers and other entities that are enabling the misuse of cryptocurrency and related technologies to commit or facilitate criminal activity." To assist NCET in its endeavor, Deputy Attorney General Lisa Monaco also announced the formation of a new FBI unit dedicated to blockchain analysis and virtual asset seizure called the "Virtual Asset Exploitation Unit."

Second, on February 14, the US Securities and Exchange Commission (SEC) entered into a no-admit consent order with BlockFi Lending LLC (BlockFi) for alleged violations related to its crypto lending product, BlockFi Interest Accounts (BIAs). Through BIAs, BlockFi allegedly borrowed crypto assets from investors in exchange for monthly interest payments to the investors in the form of cryptocurrency. BlockFi earned the interest paid to investors by taking the crypto assets and lending them to institutional and retail borrowers. Additionally, BlockFi used the crypto assets to stake crypto assets and purchase crypto asset trust shares and interests in private funds. In its order, the SEC charged BlockFi with violating the registration provisions of the Investment Company Act of 1940 and with failing to register the offers and sales of its BIAs. The order also found that BlockFi made false and misleading statements on its website regarding the level of risk in its loan portfolio and lending activity.

To date, this settlement is the largest recorded penalty incurred by a crypto firm. As part of the settlement, BlockFi agreed to pay the SEC a US$50 million dollar penalty, cease unregistered offers and sales of BIAs and undertake steps to comply with the Investment Company Act within 60 days. BlockFi also agreed to pay US$50 million in fines to 32 states to settle similar charges.

In the press release accompanying the order, SEC Chairman Gary Gensler explained that the SEC had applied "time-tested securities laws." The order found that BlockFi's BIAs constitute unregulated securities because they are both investment contracts and notes under the two main applicable cases, SEC v. W.J. Howey Co. and Reves v. Ernst & Young. Under Howey, a product is characterized as an investment contract when money is invested in a "common venture premised on a reasonable expectation of profits derived solely from the entrepreneurial or managerial efforts of others." Under Reves, notes are presumed to be securities unless they either (i) fall into certain judicially-created categories of financial instruments that are not securities or (ii) bear a "family resemblance" to notes in those categories based on a four-part test.

While Chairman Gensler characterized the SEC's action against BlockFi as a straight-forward application of "time-tested" securities law principles, SEC Commissioner Hester Peirce expressed reservations concerning the settlement. She questioned whether the order was the best approach to protecting crypto lending customers. Specifically, Peirce questioned whether the civil penalty would protect investors, given that there were no allegations that BlockFi failed to pay customers money due to them or failed to return the crypto lent to it. She also questioned whether a framework other than the securities regulatory framework might be better suited to protect customers' transparency around the terms and risk of crypto lending products and whether the Investment Company Act's purposes were being served by the consent order. Overall, Peirce was concerned that the settlement may have the unintended consequence of stopping companies from offering crypto lending products to retail customers.

Effects and implications

This order signals that the SEC views crypto lending firms as subject to registration under securities laws. Enforcement Director Gurbir Grewal stated that other similar industry participants should "come into compliance with the federal securities laws" and that "[a]dherence to [the SEC's] registration and disclosure requirements is critical to providing investors with the information and transparency they need to make well-informed investment decisions in the crypto asset space." Crypto firms will need to consider what they need to do to comply with the SEC's interpretation of the securities laws.

More broadly, the SEC's settlement, combined with the appointment of the DOJ's inaugural cryptocurrency director, underscores the government's continued enforcement focus on crypto assets that form an increasingly significant segment of the US markets and economy.

Special thanks to Law Clerk Kelly Lin in our New York office.